Trading Case OP8

 

Case Objective

To manage of the exposure of your position to loss by constructing synthetic securities.

 

Key Concepts

Synthetic securities.

 

Case description

There are three beer companies in the economy (BUD, CSP, and HEI).  The first sells medium quality beer at a medium price, while the second sells an inexpensive lower quality beer, and the third sells an expensive high quality beer.  Expected cash flows from operations for each company depend upon three factors:  exchange rates, factor input prices, and demand for premium products.  These factors are not independent from each other and the consensus of analyst forecasts for the industry estimates the following relationships among different factors to be equally probable:

 

Event 1:  strong exchange rate, very low factor input prices, strong demand for premium product.

Event 2:  positive change in the exchange rate, low factor input prices, strong demand for premium product.

Event 3:  no change in the current exchange rate, low factor input prices, weak demand for premium product.

Event 4:  no change in the current exchange rate, no change in existing factor input prices, weak demand for premium product.

Event 5:  weakening of the current exchange rate, no change in factor input prices, very weak demand for premium product.

Event 6:  weak exchange rate, high factor prices, very weak demand for premium product.

 

Projected marked event contingent values for each stock are given in table 1.

 

Fts Markets Open For Trading

Three FTS stock markets plus five FTS derivative markets are open for the first trading day of the three month period.  The stock markets allow shares to be traded in the three beer companies.  Current stock prices for BUD, CSP and HEI are $14, $22, $21 respectively.  The options markets are European options defined as follows:

A call option on BUD (Stock 1) with a strike price of 20

A put option on BUD (Stock 1) with a strike price of 10

A call option on CSP (Stock 2) with a strike price of 25

A call option on CSP (Stock 2) with a strike price of 30

A call option on HEI (Stock 3) with a strike price of 40

 

End of quarter expiration values for each option are provided in Table II, and all options are automatically exercised if they finish in-the-money. 

 

Finally, each trader has a money market account for market cash that can be accessed at any time.  The cost of funds is a fixed 16% per annum compounded quarterly.  If you are long market cash at the end of the quarter interest will automatically be accrued to your account at the rate of 4%.  Similarly, if you are short market cash at the end of the quarter, prior to all option settlements, your account is automatically be charged interest at the above rate.  Any cash transfers from option settlements will accrue (be charged) zero interest.

 

Trading Objectives

Your trading objective in this market is to manage the exposure of your position to the three economic factors (exchange rate fluctuations, factor input price changes, and demand for premium product changes).  Your initial endowment will consist of market cash plus some endowment of stock in BUD, CSP or HEI.  Each trader must take a position in the first trading day that protects the downside exposure to the three economic factors.  After the first trading day no other trading is permitted and then, at the end of the four month time horizon, a trader will receive zero grade cash if their position falls below $5000 when marked to the realized market prices that prevail at this time.  That is, dynamic hedging strategies cannot be employed in this case.  Any increase over $5000 is rewarded in the following manner:

 

At $5000 you earn $5 grade cash and greater than or equal to $9999 earns $10 grade cash.  Any intermediate market value earns grade cash in the following linear increasing relationship.

 

 

Your performance will be measured over a number of independent trials in terms of your cumulative grade cash.  Your trading type (i.e., initial position) can change from trial to trial.

 

Trading Restrictions

       1.      Each trader type is prohibited from trading the stock that they initially own.  All other securities may be traded.

 

       ii.      All traders are "market takers" in the stock markets that they are permitted to trade in.  That is, any quantity may be purchased shorted at the current market prices (BUD 14, CSP 22, and HEI 21).  The possible four monthly returns from these prices will be consistent with the consensus of analyst forecasts provided in exhibits 1 through 4.  Furthermore within-day fluctuations are not expected.

 

      iii.      All traders are "market takers" in the call option market opened for stock three (HEI).  This option is expected to trade unchanged at $1 for the first trading day.

 

      iv.      In all other markets all traders can both "make market" and "take market".

 

       v.      All traders can borrow and shortsell in any market that they are permitted to trade in.

 

Economic Events

Projected marked event contingent values for each stock:

 

Table I

Events

1

2

3

4

5

6

BUD

5

 10

10

25

25

40

CSP

15

 15

20

20

30

60

HEI

45

45

20

20

10

10

 

Option payoffs from each stock can be computed as follows:

 

Table II

 Events

1

2

3

4

5

6

BUDC20

 0

 0

0

5

5

20

BUDP10

 5

 0

0

0

0

0

CSPC25

0

0

0

0

5

35

CSPC30

0

0

0

0

0

30

HEIC40

5

5

0

0

0

0

 

 

 

 

OS Financial Trading System 2001